The estimated effect of Brexit on trade and living standards

Brexit Direction Sign

To estimate the effect of Brexit on the UK’s trade and living standards, we use a modern quantitative trade model of the global economy.

Quantitative trade models incorporate the channels through which trade affects consumers, firms and workers, and provide a mapping from trade data to welfare. The model provides numbers for how much real incomes change
under different trade policies, using readily available data on trade volumes and potential trade barriers. Our model uses the most recent data (WIOD) which divides the world into 35 sectors and 31 regions. It allows for trade in both intermediate inputs and final output in both goods and services. Additionally, the model takes into account the effects of Brexit on UK’s trade with the EU as well as UK’s global trade relations.

To forecast the consequences of the UK leaving the EU, we must make assumptions about how trade costs will change following Brexit. It is not known exactly how the UK’s relations with Eurozone countries will change following Brexit, which means that there is a lack of clarity over the consequences of Brexit for trade costs between the UK and EU countries. To overcome this difficulty, we analyse two scenarios: an optimistic scenario in which the increase in trade costs between the UK and EU is small, and; a pessimistic scenario with a larger rise in trade costs.

The optimistic scenario assumes that in a post-Brexit world, the UK’s trade relations with the EU are similar to those currently enjoyed by Norway. As a member of the European Economic Area (EEA), Norway has a free trade agreement with the EU, which means that there are no tariffs on trade between Norway and the EU. Norway is also a member of the European single market and adopts policies and regulations designed to reduce non-tariff
barriers within the single market. But Norway is not a member of the EU’s customs union, so it faces some non-tariff barriers that do not apply to EU members such as rules of origin requirements and anti-dumping duties.

Campos et al (2015) found that Norway’s productivity growth has been harmed by not fully participating in the EU’s market integration programmes.

In the pessimistic scenario, we assume that the UK is not successful in negotiating a new trade agreement with the EU and, therefore, that trade between the UK and the EU following Brexit is governed by World Trade Organisation (WTO) rules. This implies larger increases in trade costs than the optimistic scenario because most favored nation (MFN) tariffs are imposed on UK-EU trade and because the WTO has made less progress on reducing non-tariff
barriers than the EU.

Increases in trade costs between the UK and the EU following Brexit can be divided into three parts: (i) higher tariffs on imports; (ii) higher non-tariff barriers to trade (arising from different regulations, border controls, etc.); and (iii) the UK may not participate in future steps that the EU takes towards deeper integration and the reduction of non-tariff barriers within the EU.

In the optimistic scenario, we assume that the UK and the EU continue to enjoy a free trade agreement and Brexit does not lead to any change in tariff barriers. In the pessimistic scenario where trade is governed by WTO rules, we assume MFN tariffs are imposed on UK-EU goods trade.

Regarding non-tariff barriers, in the optimistic scenario, we assume that UK-EU trade is subject to one quarter of the reducible non-tariff barriers that are observed in trade between the United States and the EU. In the pessimistic scenario, we assume a larger increase of three quarters of reducible non-tariff barriers.

Finally, trade costs between countries within the EU have been declining approximately 40% faster than trade costs between other OECD countries (Méjean and Schwellnus, 2019). In the event of Brexit, the UK would not benefit from any future reductions in intra-EU trade costs.

In the optimistic scenario, we assume that in the ten years following Brexit, intra-EU trade costs fall 20% faster than in the rest of the world, while in the pessimistic scenario, we assume intra-EU trade costs continue to fall 40% faster than in the rest of the world. This implies that in the optimistic case, non-tariff barriers within the EU fall 5.7% over the next decade, while in the pessimistic case they fall by 12.8%. Our estimates also account for fiscal transfers between the UK and the EU. Like all EU members, the UK makes a contribution to the EU budget. The net fiscal contribution of the UK to the EU budget has been estimated to be around 0.53% of national income.

One benefit of Brexit for the UK would be a reduced contribution to the EU budget. But Brexit would not necessarily mean that the UK would make zero contribution to the EU budget. In return for access to the single market, EEA members such as Norway make substantial payments to the EU. On a per capita basis, Norway’s financial contribution to the EU is 83% as large as the UK’s payment (House of Commons, 2013). Therefore, in the optimistic case we assume that the UK’s contribution to the EU budget falls by 17% (that is, 0.09% of national income).

In the pessimistic case where the UK is outside the EEA, we assume that the UK saves more of its current contribution. The 0.53% saving includes only the public finance components so excludes all the transfers the EU makes directly to universities, firms and other nongovernmental bodies. Under the reasonable assumption that post-Brexit the UK government does not cut this funding, the saving is 0.31% according to Eurostat. This cost essentially comes from the agricultural subsidies in the Common Agricultural Policy.